A Fiscal Solution to the Economic Crisis

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A Fiscal Solution to the Economic Crisis?

• Professor William T. Dickens
• Northeastern University,
• The Russell Sage Foundation, and
• The Brookings Institution

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What Im Going to Talk About

• How fiscal policy can restore full employment
• Why we dont normally resort to fiscal policy in
  recessions but need to now
• How much will the fiscal stimulus plan being
  contemplated help?

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My View

• We face a nearly unprecedented global economic
  crisis with the potential to be the worst
  economic catastrophe in 75 years
• We need rapid action in the US to shore up our
  financial markets and to prevent further collapse
  of employment and income
• Fiscal policy will have to carry the main part of
  the burden of shoring up employment and income
  because monetary policy has become much less
  effective than it normally is
• The package of fiscal stimulus that looks headed
  for passage is a large step in the right
  direction but is probably too small to restore
  full employment and may not come in time to
  prevent further problems in financial markets
• Thus I expect that we will need further rounds of
  fiscal stimulus before our economy recovers, with
  the speed of the recovery depending on how
  quickly we realize and act on this

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Definitions

• Recession
• A recession is a significant decline in economic
  activity spread across the economy, lasting more
  than a few months (NBER Business Cycle Dating
  Committee)
• Depression
• When economists have to worry about their jobs
  too

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The Current RecessionThe Downward Spiral
Demand for buildings and equipment
Employment and Income
Credit Crunch
Consumption Multiplier
Investment Accelerator
Demand for Consumer Goods and Services

• What starts in one sector of the economy ends up
  affecting all sectors of the economy

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Why Doesnt the Downward Spiral Go On Forever?

• Each round of the spiral is smaller than the last
  due to leakages
• When income falls, people cut their spending by
  less than their incomes fell using savings and
  credit to make up the difference
• When incomes fall people pay less in taxes
• When incomes fall people get unemployment
  insurance and other transfer payments
• When incomes fall people cut their spending on
  imports (which doesnt reduce domestic
  employment)
• In the end, the sum of the total effect is
  thought to be about 1.5 to 2 times the initial
  decline in spending (investment plus consumption)

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How Fiscal Expansion Remedies Downturn
Tax Cuts
Directly Employs Workers
Government Spending
Employment
Income
Demand for Houses, Goods and Services
Incentive Effects
Businesses Buy More Machines and Buildings

• If spending increases and tax cuts are big
  enough they can completely offset effects of
  credit crunch in previous slide.

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Tax Cuts or Spending?

• With spending there is no leakage from first
  round employment and income rise one-for-one
  with increased spending (so long as money is
  spent on unemployed resources and doesnt shift
  people from other employment)
• With a tax cut the impact is reduced by all the
  leakages primarily people saving significant
  parts of the tax cut (partial solution is to give
  tax cuts to people who are cash strapped)

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Spending or Tax Cuts?

• Tax cuts have incentive effects on top of just
  increasing income (by making work pay more or
  investment less expensive you get more capital
  and labor)
• Tax cuts will typically be faster acting (no long
  lags in planning, contracting and then paying out
  the money)

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So Why Not Cut Taxes and Increase Government
Spending All the Time?

• If there are no unemployed resources then
  government spending only displaces private sector
  spending (consumption and investment).
• When there is full employment, tax cuts without
  spending cuts force the government to borrow
  which drives up interest rates and crowds out
  investment spending by businesses and slows
  growth (unless Federal Reserve keeps interest
  rates down by printing money in which case there
  is inflation).

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So Why Arent There Calls for Big Fiscal Stimulus
Packages in Every Recession?

• To some extent there are (we often put tax cuts
  and spending increases into effect to combat
  recessions)
• But in every recession since WWII the primary
  cause of the recovery has been action by the
  Federal Reserve bank
• Federal Reserve cuts interest rates
• This stimulates demand for housing, business
  investment, and consumer durable goods
  (appliances and cars things people tend to buy
  with credit)

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So Why Not Leave it to the Fed Now?
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The 0 Lower Bound

• No one will lend money at less than 0 interest
  since they can get that rate of return on cash
  under their mattress -- the primary interest
  rates the Fed targets cant go any lower!
• This is similar to the situation in the Great
  Depression and why people keep comparing the
  current situation to those times
• Also very similar to the problems faced by the
  Japanese in the 1990s.

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So How Far Will Recovery and Reinvestment Act
Take Us?

• Both Senate and House versions of H.R. 1 are
  estimated to cost about 820 billion dollars
• House bill is about 78 spending and 22 tax cuts
• Senate bill is about 65 spending and 35 tax cuts

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Criticism of the Stimulus Bill

• Unfair
• Spending has been tried and failed (1930s, Japan
  in the 1990s).
• Contrary to conventional wisdom, Roosevelt didnt
  do much spending until run up to WWII. Japanese
  did use fiscal stimulus but always too little too
  late.
• Full of pork.
• Very careful about restricting earmarks.
  Democrats say that the programs the Republicans
  call pork are what they were elected to put in
  place.

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Criticism of the Stimulus Bill

• Fair
• Several new spending programs that are lumped
  together in bill deserve to be considered
  individually and not rushed through with little
  opportunity for deliberation and debate
• Spending spread out over 10 years while stimulus
  is needed now

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So How Does the Bill Measure Up?
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What is in Senate and House Bills vs. What is
Needed
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What I Would Have Done Differently

• Aim higher cost of undershooting much worse
  than overshooting
• More of the stimulus upfront (2009)
• More relief for state budgets
• Further extensions/expansions of Food Stamps, UI,
  and Medicaid
• More tax cuts and consumption subsidies
• More shovel ready infra-structure(?)
• I am very worried that by not doing enough we are
  inviting even more problems with financial
  markets and that the cost of rescuing the economy
  will continue to climb